Law firm economics during crisis

During times of economic crisis, law firms need to be even more careful with the economics of their practice, according to writer Shannon Nelson of Law360.

Firms Need To Toe Economic Line During Slump

Law firms that have long relied on their cozy relationships with bankers and status as low credit risks need to keep an eye on the bottom line as available credit dries up amid the economic slump.Experts said that law firms that have enough cash on hand to pay for a few months’ worth of operating expenses are following good billing practices and aren’t paying partners with loaned money should be well-positioned to weather the storm. But prudence is required in an environment where banks aren’t loaning money to one another – let alone to law firms and law firm clients.”Most of the larger firms at least operate with a line of credit,” said Bob Henderson of Wyoming-based RJH Consulting. “And just like it is for any other business, it’s harder to borrow and it’s more costly when banks are tight with money. So it’s definitely having an impact.”

Ed Poll, principal at LawBiz management, said law firms and banks often enjoy reciprocally beneficial relationships, which may benefit law firms at a tough time such as this.

“I don’t think lawyers really understand how valuable the bank is to them, not just in terms of loaning money but also for referring new business,” Poll said. “And reverse that equation. How good is a law firm to the bank? I think very good, and banks are willing to make allowances for the service nature rather than the collateral because they know each of the partners is, generally speaking, an upper echelon income earner and that they are going to have more money going into accounts.”

However, he said banks still need to be assured that they are going to be repaid or they won’t loan money. “Banks are going to be far more cautious” in this economy, Poll said.

For some law firms, the conditions of the credit market could be dire because they heavily rely on loans. Specifically, firms that work on a contingency basis are “basically in bed with the bank,” said Joel Rose of Joel A. Rose & Associates Inc.

But the bulk of most law firms’ revenue comes in, logically, from fees. Firms that aren’t diligent in their collection efforts are most likely to be vulnerable in this economic environment.

“Firms need to be focused on collecting accounts receivable,” Poll said. “If, say, AIG was a client, and it’d be a big client, meaning a lot of lawyers would be working with them, that money would likely never appear. You have to make sure your collection and realization rate is up there. A focus on collection is the most important element for the survival of a law firm.”

However, Poll said most law firms aren’t very conscientious about collections. “They collect two thirds of their revenue in the last third of the year. They aren’t business people and they don’t understand the importance of it. Every firm that understands it, generally speaking, does well.”

Tony Williams, principal in Jomati Consultants, said that even law firms who take collections seriously need to redouble their efforts.

“If you don’t understand the value of cash right now, your clients do. You have to assume it will take longer to collect, so you have to be more rigorous in your collections. You have to make sure you’ve got cash coming in,” Williams said.

Rose said that many clients are taking longer to pay their attorney bills, possibly because they can’t access credit themselves.

“If banks loan money to the clients of the law firms then there aren’t any deals and things aren’t getting done.”

Henderson and other consultants said that banks find law firms to carry varying credit risks based on their business models and other things.

“There are some firms that would be better credit risks than others,” Henderson said. “The thing that makes law firms different from a company that makes products is their ability to offer security for a loan. About all a firm has to offer is their accounts receivable, and a lending institution, particularly in today’s market, is going to take a hard look at that.”

Williams, who is based in the United Kingdom, said that banks there traditionally see law firms as a low credit risk. “Very rarely have they lost money on law firms over the years, but now [law firms] are like everybody else in this credit crisis. Banks don’t want to lend money or they haven’t got the money to lend out.”

He said that he has heard firms are having a harder time getting loans and are being asked to pay higher rates to do so.

“The problem is what they want the money for. If they want it because they haven’t managed their receivables well or because they want to pay out partners, they are going to get little sympathy,” Williams said.

Rose recommends that law firms have three or four months worth of operating capital – excluding partner compensation – squirreled away.

“A great number of law firms, especially mid-sized firms, think they don’t need to have that much in reserve because they have a credit line,” he said. “But if the clients aren’t paying and new business isn’t coming in, then unless the firm has a sufficient amount of capital, partners don’t get paid or they have to go to the bank and borrow.”

And Poll said that firms need to be careful when considering what to use their credit lines to pay for. “If it’s used to pay partners, they are in danger.”